Tax-Smart Ways to Help Your Kids or Grandkids Pay for College

Your child (or grandchild) might be just a two-year-old, but it’s not too early to start figuring out how you’ll pay for college. Here’s why: according to the College Savings Plans Network, it’s estimated that an inflation rate of 6%, it will cost $261,277 to send a child who is a toddler in 2021 to an in-state, public college for four years, including tuition, fees, room, and board. Are you thinking about a private college? That’s going to run $598,063 by the time your toddler is ready for higher education!

Cost of Going to College

College costs tend to increase at about two times the rate of inflation each year; a trend that is expected to continue for the foreseeable future. Here’s what you can expect to pay for each year of tuition, fees, and room and board by the time your kids (or grandkids) are ready to head off to college (assuming a steady 6% college cost inflation rate):

Note: Want an estimate of how much it will cost to send your child or grandchild to college? Use the College Cost Calculator at the College Savings Plans Network.

Keep in mind, these numbers represent a single year of costs; the number of years your child attends college will depend on the degree(s) they are seeking. While many students will qualify for financial aid, scholarships, and grants to help cover college costs, there are a number of ways to trim college costs.

One of the easiest ways is to invest the money you’ve set aside for your child or grandchild’s college years is in tax-smart investment vehicles. These plans and accounts allow you to efficiently save for your child or grandchild’s education while shielding the savings from the IRS as much as possible.

529 Plans

“One of the best ways to help a child financially while limiting your own tax liability is to use a 529 college plan,” says Sam Davis, partner/financial advisor with TBH Global Asset Management. A 529 plan is a tax-advantaged investment plan that lets families save for the future college costs of a beneficiary.

Plans have high limits on contributions, which are made with after-tax dollars. You can contribute up to the annual exclusion amount each year, which is $15,000 in 2021 (the “annual exclusion” is the maximum amount you can transfer by gift, in the form of cash or other assets, to as many people as you wish, without incurring a gift tax). The amount will increase to $16,000 in 2022. All withdrawals from the 529 are free from federal income tax as long as they are used for qualified education expenses (most states offer tax-free withdrawals, as well).

Those who have the funds can “superfund” a 529 plan by contributing five years of gifts at once, per child, per person without being subject to the gift tax. This means, for example, that a pair of super-wealthy grandparents could contribute $75,000 each ($150,000 per couple) when a child is young and let that money grow to cover their entire costs. There are complicated rules about how to do this, so don’t try it without detailed tax advice.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law by President Donald Trump in December 2019, created multiple provisions intended to improve retirement and savings plans. Under the new law, 529 plan funds can now be used to pay off up to $10,000 in student loans, and the funds can also be used to pay for expenses related to registered apprenticeship programs.

Types of 529 Plans

There are two types of 529 plans:

College Savings Plans

These savings plans work like other investment plans, such as 401(k)s and individual retirement accounts (IRAs), in that your contributions are invested in mutual funds or other investment products. Account earnings are based on the market performance of the underlying investments, and most plans offer age-based investment options that become more conservative as the beneficiary nears college age. The 529 savings plans can only be administered at the state level.

Prepaid Tuition Plans

Prepaid tuition plans (also called guaranteed savings plans) allow families to lock in today’s tuition rate by pre-purchasing tuition. The program pays out at the future cost to any of the state’s eligible institutions when the beneficiary is in college. If the beneficiary ends up going to an out-of-state or private school, you can transfer the value of the account or get a refund. Prepaid tuition plans can be administered by states and higher education institutions, though a limited number of states have them.

“I strongly advise my clients to fund 529 plans for the unsurpassed income tax breaks,” Davis says. “Although the contributions are not deductible on your federal tax return, your investment grows tax-deferred, and distributions to pay for the beneficiary’s college costs come out federally tax-free.”

Traditional and Roth IRAs

An IRA is a tax-advantaged savings account where you keep investments such as stocks, bonds, and mutual funds. You get to choose the investments in the account and can adjust the investments as your needs and goals change.

Under the SECURE Act, you can now wait until age 72 to begin taking required minimum distributions (RMDs), and the law removed the age requirement for depositing money into a traditional IRA, so you can continue making contributions at any age if you are still working. In general, if you withdraw from your IRA before you are 59½ years old, you will owe a 10% additional tax on the early distribution.

However, you can withdraw money from your traditional or Roth IRA before reaching age 59½ without paying the 10% additional tax to pay for qualified higher education expenses for yourself, your spouse, or your children or grandchildren in the year the withdrawal is made. The waiver applies to the 10% penalty only; you will still owe income tax on the distribution unless it’s a Roth IRA.

Drawbacks

Using your retirement funds to pay for your child or grandchild’s college tuition does come with a couple of drawbacks:

1. It takes money out of your retirement fund—money that can’t be put back in (unless you are still working)—so you need to make sure you are well-funded for retirement outside of the IRA.
2. IRA distributions can be counted as income on the following year’s financial aid application, which can affect eligibility for need-based financial aid.

To avoid dipping into your own retirement, you may be able to set up a Roth IRA in your child’s or grandchild’s name. The catch: Your child (not you) must have earned income from a job during the year for which a contribution is made. You can actually fund their annual contribution, up to the maximum amount, but only if they have earnings.

The IRS doesn’t care where the money comes from as long as it does not exceed the amount your child earned. If your child earns $500 from a summer job, for example, you can make the $500 contribution to the Roth IRA with your own money, and your child can do something else with their earnings. 

Here’s how to do it: If your child is a minor (younger than 18 or 21 years old, depending on the state in which you live), many banks, brokers, and mutual funds will let you set up a custodial or guardian IRA. As the custodian, you (the adult) control the assets in the custodial IRA until your child reaches the age of majority, at which point the assets are turned over to them.

Coverdells

A Coverdell Education Savings Account (ESA) can be set up at a bank or brokerage firm to help pay the qualified education expenses of your child or grandchild. Like 529 plans, Coverdell ESAs allow money to grow tax-deferred and withdrawals are tax-free at the federal level (and in most cases, the state level) when used for qualifying education expenses.

Coverdell ESA benefits apply to higher education expenses, as well as elementary and secondary education expenses. If the money is used for nonqualified expenses, you will owe tax and a 10% penalty on earnings.

Coverdell ESA contributions are not deductible, and contributions must be made before the beneficiary reaches age 18 (unless the child is a special needs beneficiary, as defined by the IRS). While more than one Coverdell ESA can be set up for a single beneficiary, the maximum contribution per beneficiary—not per account—per year is limited to $2,000.

Custodial Accounts

Uniform Gifts to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts are custodial accounts that allow you to put money and/or assets in a trust for a minor child or grandchild. As the trustee, you manage the account until the child reaches the age of majority (18 to 21 years of age, depending on your state). Once the child reaches that age, they own the account and can use the money in any manner they wish. That means they don’t have to use the money for educational expenses.

Although there are no limits on contributions, parents and grandparents can cap individual annual contributions at $15,000 per individual ($30,000 per married couple) to avoid triggering the gift tax. These amounts will increase to $16,000 and $32,000, respectively, in 2022. One thing to be aware of is that custodial accounts count as students’ assets (rather than parents’), so large balances can limit eligibility for financial aid. The federal financial-aid formula expects students to contribute 20% of savings, versus a maximum of 5.6% of savings for the parents.

Cash

The annual exclusion allows you to give $15,000 in 2021 (increasing to $16,000 in 2022) in cash or other assets each year to as many people as you want. Spouses can combine annual exclusions to give $30,000 (increasing to $32,000 in 2022) to as many individuals as they like—tax-free.

As a parent or grandparent, you can gift a child up to the annual exclusion each year to help pay for college or other higher education costs. Gifts that exceed the annual exclusion count against the lifetime exemption, which is $11.7 million per individual in 2021 (increasing to $12.06 million in 2022).

Concerned about the lifetime exemption? As a grandparent, you can help your grandchild pay for college while limiting your own tax liability by making a payment directly to their higher-education institution.

As Joanna Foster, MBA, CPA explains, “Grandparents can pay the educational expense directly to the provider, and that does not count against the annual exclusion of $15,000.” So, even if you send $20,000 a year to your grandchild’s college, the amount over $15,000 ($5,000 in this case) would not count against the lifetime exemption.

The Bottom Line

Many people approach saving for college the same way they approach retirement: They do nothing because the financial obligations seem insurmountable. Many people say their retirement plan is never to retire (not a real plan, needless to say, unless you die young). Similarly, parents might joke (or assume) that the only way their kids are going to college is if they get a full scholarship.

Aside from the obvious flaw with this plan, it’s a back-seat approach to a situation that really needs a front-seat driver. Even if you can save only a small amount of money in a 529 or Coverdell plan, it’s going to help.

For most families, paying for college is not as simple as writing a check each quarter. Instead, it’s an amalgamation of financial aid, scholarships, grants, and money that the child has earned as well as money that parents and grandparents have contributed to tax-smart college savings vehicles.